After launching my career in and around the high impact entrepreneurship space and venture capital in Silicon Valley in 1985, I moved on to North Carolina in 1990. After an .. exhilarating? … run as a venture capital investor (fund class of 1999 which, if you know the history of the business, is more than enough said) I proved to myself, at least, that sometimes you can just go home. In my case, home was Neenah, Wisconsin.

My career is still all about high impact entrepreneurship and investing: my experiences over the last ten years demonstrate that high impact entrepreneurship is doable in Wisconsin. More than that, it has, I think, a bright future. But … and this is where I tend to get into trouble … let’s not kid ourselves. Wisconsin’s high impact entrepreneurs, circa 2014 and for some indeterminate time to come, as a rule (there are exceptions, but mostly of a kind that prove the rule) face more and more daunting challenges than their peers in Silicon Valley. Or even New York or Austin, for that matter; but let’s be straight about it. Silicon Valley is the gold standard for high impact entrepreneur environments.

Last week, at the Wisconsin Entrepreneurs’ Conference, I was on a panel talking about common mistakes entrepreneurs make. And I said something, publicly, that I have said privately before. To wit that if a high impact entrepreneur’s only objective is to raise the most venture capital, as fast as possible, at the highest price, that entrepreneur should move to Silicon Valley.

Being that the setting was, as mentioned, the Wisconsin Entrepreneurs’ Conference (and kudos to the Wisconsin Technology Council for another great event), my declaration was not particularly embraced by the crowd. But it is what it is. Silicon Valley is to the high risk entrepreneurship and investing world what Rome was to the Roman Empire. It is where pretty much all of the significant roads lead. It is where about one half of all the venture capital in the country is invested (that would be two orders of magnitude more venture capital than has historically been invested in Wisconsin). The Silicon Valley entrepreneur/venture capital eco-system is by far the broadest and deepest in the world. That is not a boast, that is just a fact.

But if Silicon Valley is the center of the technology-driven entrepreneurship and investing universe it is no more the only place in that universe than Rome was the only place that mattered in the days of the Empire. Entrepreneurs can and do build great companies in places like Wisconsin. They do it because raising the most money at the best price as fast as possible is not their only objective. They do it because while it might be easier to build a startup bigger, better and faster in Silicon Valley, they want to do it somewhere else – like Wisconsin. And, frankly, I applaud them for it. Selfishly, if there were not entrepreneurs and risk capital investors who wanted to do their thing in Wisconsin even if it might be harder to do here than there, well, I would not have anything, career-wise, to do here. And I like it here, too.

So if you are one of “us,” that is one of those folks in the high impact entrepreneurship and investing space that calls Wisconsin home, three cheers. But do it with your eyes open. You can get financed in Wisconsin. You can build winning high growth/risk teams in Wisconsin. You can find savvy startup lawyers, accountants, advisers, mentors and partners in Wisconsin. But it will likely take a little more time and effort than it would in Silicon Valley. And you will most likely have to compromise a bit more on your financing, growth and exit expectations. Good for you. You gotta love our winters.

In an earlier blog (Capping Preferred Participation: A Compromised Compromise) I argued that the usual middle ground between entrepreneur-friendly “non-participating” preferred stock and investor-friendly “participating” preferred stock – capping participation at some multiple of an investor’s base preference – is seriously flawed. Herewith an alternative approach.

By way of a quick refresh, we are talking about “participation” in the context of a preferred stock liquidation preference. In an exit transaction (other than an IPO) an investor holding “participating” preferred shares gets two bites at the exit proceeds apple. First, a bite equal to his base preference (typically an amount equal to his investment) and then a second bite equal to his pro-rata share of the remaining exit proceeds.

An example. An investor who put down $1 million for a 40% ownership position in Newco in the form of “participating” preferred shares would, in the event Newco was sold for $3 million, receive $1 million “off the top” and in addition 40% of the remaining $2 million of proceeds, for a total of $1.8 million. That means the investor, who owned 40% of Newco when it was sold, would get 60% of the exit proceeds. If, instead, the investor held “non-participating” preferred shares he would, in this example, receive either (at his option) (i) his $1 million base preference or (ii) his 40% pro-rata share of the $3 million, or $1.2 million. Clearly, the investor would take the $1.2 million pro-rata share. And leave the entrepreneur with $400,000 more money than he would have had if the investor had held participating preferred.

Looking at the above example, it is not hard to see why entrepreneurs don’t like participation and investors do: while the relative impact of the participation right diminishes as the exit proceeds rise (in the example, the difference is always $400,000), at every exit that leaves anything for the common shares, the investor with participating preferred gets more and the entrepreneur less.

In light of the above, entrepreneurs and investors long ago came up with a compromise on the participating/non-participating issue, the so-called “participation cap.” As with non-participating preferred, “capped” participating preferred gives an investor a choice. When exit proceeds are being distributed, the investor can choose to take either his pro-rata share of the proceeds (his percentage ownership at the exit) or his base preference plus participation in the distribution of the remaining proceeds until he has received in the aggregate an amount up to some multiple – say 2x, or 3x, etc. – of his base preference.

Now at first glance, capped participation seems like a reasonable compromise on the participation/non-participation negotiation. As my earlier blog pointed out, however, it is a compromised compromise. The problem – if you don’t want to go back and review the prior blog, just trust me on this – is that when you cap the participation preference you create a situation where there is range of exit proceeds (a “zone of indifference”) where an investor doesn’t care what the exit proceeds are. In the example in the earlier blog the investor got the same payout ($4.5 million) for exit proceeds anywhere between $6 million and $9 million. Faced with a deal that promised $6 million in exit proceeds, the investor would have no incentive to negotiate for a higher price unless he thought he could get the price up at least to $9 million plus one dollar – in which case the investor would get a fraction of that final dollar. A savvy entrepreneur should, it seems to me, be skeptical of an arrangement where an investor was indifferent over how much money the company was sold for over a significant range of plausible exit scenarios.

Fortunately, there is a better compromise, to wit “partial participation.” In this compromise, the entrepreneur and investor agree that the investor’s “second bite” at the proceeds apple will be some fraction of the investor’s pro-rata ownership share. So, for example, that fraction might be one-half. Going back to our initial example where the investor has invested $1.0 million for a 40% ownership interest, and the exit proceeds amounted to $3 million, the investor would first get his base preference ($1 million) and then get an additional $400,000 (one-half of 40% of the remaining proceeds). The “second bite” would be worth exactly one-half of what it would be worth if the investor had full participation. If the partial participation fraction was set at one-quarter, the “second bite” would be worth exactly one-quarter what it would be worth compared to full participation, and so on.

Compared to capped participation, partial participation is much easier to understand – the compromise consists of picking a fraction between 0 and 1, which such fraction perfectly represents the way the compromise plays out as a fraction of full participation. But even more important, partial participation has another big advantage over capped participation: there is no zone of indifference. There is no range of exit prices where the investor is anything less than fully incented to work with the entrepreneur to negotiate a better price. And that, for me, makes partial participation a better participation compromise.

Ok, being a lawyer in the high impact entrepreneur space myself, writing this blog (well, posting it) is a bit awkward. But having seen – not only as a lawyer but also as a serial venture-backed entrepreneur myself, as well as venture capital and angel investor – so many entrepreneurs squander so much money, energy and time working with the wrong lawyers (and more than a few deals crater as a result), well, it just has to be done. So here goes: my advice to high impact entrepreneurs on picking a lawyer.

Rule number one: pick a lawyer who spends at least a majority of her time working with high impact entrepreneurs and investors. These folks may not be any better at what they do than lawyers who spend their time in other areas – say, for example representing traditional small businesses or large businesses. But just as, when you have a problem with your knee, you look for an orthopedic specialist (and maybe even a knee specialist) rather than a cardiologist, so when looking for a lawyer for your startup you should look for a lawyer who specializes in that market niche.

If you need some convincing on this, here are some of the things that distinguish counseling high impact entrepreneurs from counseling other business clients.

1. Startup lawyers should be comfortable and effective regularly working directly with entrepreneurs and their business and technology teams as well as their investors. That’s something that most lawyers who spend their time with bigger, more established business clients don’t generally have to do.
2. High impact entrepreneurs and their startups have much higher risk/reward profiles than their small and big business counterparts. As a result, they are best served by lawyers who are comfortable and effective providing legal support for business strategies and tactics that lawyers accustomed to representing traditional small and larger businesses would find, well, too risky. Put differently, while lawyers for traditional small and larger businesses tend to look for reasons to say “no” to their clients, lawyers for high impact startups tend to look for ways to say “yes.”
3. Angel and venture capital financing, the typical financing vehicles for high impact startups, are substantially different from the typical financing vehicles for traditional small and big businesses. A high impact startup with a lawyer who doesn’t regularly represent clients in angel and venture capital transactions will almost certainly find the process more expensive and time consuming than it should be. Worse, I have seen deals that should have been done founder on inappropriate counseling by otherwise quite competent but out-of-their-niche lawyers, both at the closing of the instant deal and later on, when the company needs follow on capital.
4. Finally, lawyers who regularly work with startups understand that most startups are, at various times, cash-poor. That does not mean good startup lawyers are cheap (indeed, good startup lawyers are typically more expensive than their colleagues who focus on traditional small businesses). But they are typically more flexible in terms of their billing and collections procedures than most other business lawyers. Beware, though, both the too-accommodating startup lawyer (their flexibility might reflect limited demand for their services) and the too rigid startup lawyer (their lack of flexibility might reflect a poor appreciation of the financial realities of the startup world).

Rule number two. Pick a lawyer who has the time, talent, experience and curiosity to understand your vision, your business, your markets and your technology. At a larger, more established company, an in-house “General Counsel” is usually charged with making sure the advice of the businesses lawyers, whether in-house or outside, reflects a solid understanding and appreciation of the larger business the advice is supposed to serve. Lacking that filter, high impact startups should make sure their outside counsel can provide that critical “General Counsel” filter.

Rule number three (an extension of rule two, really). Pick a lawyer who can add value to your startup beyond just legal advice. The best startup lawyers I have worked with have all been lawyers who were quite capable of and eager to share their business and sometimes even technology advice with their clients, and beyond that to leverage their own business, technology and financial networks on behalf of their clients.

Now for something to think about, rather than a hard and fast rule. Pick a lawyer – and that usually means a law firm – that can grow with your startup, hopefully to and through a huge exit. My experience includes working with some “small firm” startup lawyers who were quite effective representing their clients in the early stages, and were capable at bringing in other firms for particular matters – litigation, patents, regulatory, etc. – as their startup clients grew and their needs evolved. That approach can be fraught with peril, though, in terms of managing multiple relationships and matters across multiple law firms. In my view, absent a compelling reason to work with a solo or small firm startup lawyer, choose a lawyer with a larger “full-service” firm that has the resources to grow with your startup.

So, my advice on choosing a lawyer for your startup. Self-serving? You bet. But you wanted good advice, right?

High impact entrepreneurs know – or learn pretty fast – that most angel and even most venture funds outside of the major venture centers take a perverse satisfaction in telling entrepreneurs that they are being naïve when they build the proverbial “hockey stick” growth assumption into their business plans. A lot of self-identified “smart” high impact investors (particularly those of limited means) can be downright smug in their “you are not another one of those crazy kids carrying a hockey stick” comments as they flip through your pitch deck. “That kind of growth almost never happens.”

Well, I am here to tell you that the right response to those kinds of remarks – assuming, that is, you really have a venture capital worthy deal – is something like this: “Of course we are – we wouldn’t be here if we weren’t.”

It is indeed true that most venture-backed high impact startups either never get to the inflection point of the hockey stick growth curve, or if they get that far, fall off the curve shortly thereafter. That, though, says very little more than that most venture-backed high impact startup investments don’t come close to delivering the 10x returns which their venture backers were hoping for when they put their money down. If you focus instead on the deals that do deliver on their home run promise, you will find that most of those did – at some point – reach the inflection point and subsequently crawl pretty far up the growth curve.

The truth is, if you can’t convince a potential investor that there is hockey stick growth out there somewhere for you, how can you possibly show them a path for a 10x return on their investment? I suppose it might be possible in some cases to do that if you set the pre-money valuation low enough, but if you do that you are probably leaving nothing but crumbs on the table for you and your team.

No, if you want to raise real money from real venture investors for your startup, you are going to have to project hockey stick growth on some metric (revenue is the obvious one, but things like eyeballs can work in some markets), at some point, in your plan/pitch. An investor who thinks you are too optimistic about when you get to the inflection point on the curve may have a point. And so might an investor be right is saying that your deal will never get to that inflection point. But an investor who thinks hockey sticks just don’t happen, well, that investor just doesn’t understand her own business. Which, I think, is reason enough to look elsewhere for capital. Focus on investors who respect the stick.

High impact angel investing in the major venture capital centers is not without its special challenges. That said, problems like a target rich environment of experienced entrepreneurs and a plethora of alternative funding options are, as they say, pretty high quality problems to have. Outside of the major venture centers, angels face another set of problems; problems that on the whole make successful angel investing in these locales more challenging than it is for their venture center counterparts. Herewith some thoughts on the special challenges of high impact angel investing in places like the Midwest, and how those challenges might be addressed.

Challenge: Good angel investing “people” resources – experienced angels, venture investors, entrepreneurs and high impact investing and entrepreneurship service providers – are much scarcer. This makes it harder for the new angel to learn about and keep up with “best practices.”

Addressing the Challenge: First, try and find locals who have venture center experience and/or perspective, and people who acknowledge and understand the special challenges of high impact angel investing outside of the major venture centers. Focus as well on other angels, lawyers, etc. who not only talk the talk but have a verifiable record of walking the walk.

Challenge: The supply of less sophisticated “wannabe” angel investors and advisers is relatively plentiful. These folks don’t know a lot about the subject, but often think of themselves as experts, and create a lot of noise in the market.

Addressing the Challenge: Be very careful who you take advice from. Be especially wary of folks who tell you their approach to an issue “isn’t the way they do it in Silicon Valley, but we know better around here. It stands to reason – even allowing for the occasional outlier – that the venture centers are the more likely source of best practices than the hinterlands. Further, no matter how tempting, don’t get sucked into a good deal that a less sophisticated set of local investors have gone into at a ridiculous price. Finally, if you find yourself playing a follower role in a deal led by a local lead of questionable capabilities, discretely do your own due diligence as if you were instead leading the deal.

Challenge: Entrepreneurs outside of the major venture capital centers are generally much less experienced in terms of working with sophisticated angel and venture investors, and building startup high impact businesses. Worse still, they have often sought the advice of well-meaning folks in the community who may have a lot of knowledge about small and big business management and investing, but little or no knowledge of high impact entrepreneurship and investing (see preceding challenge).

Addressing the Challenge: This a challenge is best thought of as an opportunity in disguise. If (i) you can sort spot the diamond in the rough entrepreneur among all the fools gold; and (ii) you are willing to invest the extra time and energy polishing that entrepreneur; you can often find and invest in hidden gems that other angels either can’t identify or can’t/won’t put the time and energy into value added mentoring. And that can be a great way to get into great investments at below market prices.

Challenge: Venture capital – the primary source for post-angel high impact investment capital – is very hard to find outside of the major venture centers. This is true in terms of the number of investors and the total investable capital under management. And, unfortunately (if not altogether without justification) venture capital investors on the coasts are generally cautious to a fault about the notion of investing in post-seed but still early stage opportunities very far from their coastal homes.

Addressing the Challenge: Angels in venture-scarce locations must generally include elevated financing risk as a critical part of their investment decision making and management. That can, of course, be one reason deals outside of the major venture centers are generally done at lower valuations. But at least as important, it means that deals should be structured – think in terms of capital needs, early cash flow, and time to exit – to match the likely limited supply of local downstream investors and capital. Focus on business models that call less than $5 million of risk capital and 3-5 years to the exit.

While high impact angel investing outside of the major venture centers is not without it special challenges, so it can have its special rewards. If you are thoughtful about dealing with this challenges, there are good investments to be had at good prices. And, as important for many, an opportunity to help build a high impact entrepreneurship and investing community in a region not already blessed with the same.

If you know anything about venture capital investing, you probably know that most plans that come across the desks of venture capitalists (and angels, for that matter) are not fundable. That is, they are of so little merit that no half-way competent investor would back them at any price.

While lots of plans get rejected because they are frankly bad, in my own experience as an entrepreneur, angel and institutional venture capitalist I have been struck by how many fundable deals get turned down by so many competent investors. (If you don’t believe me checkout http://www.bvp.com/portfolio/antiportfolio, where Bessemer Ventures reviews some of the ultimately hugely successful deals that they turned down over the years.) Herewith some of the reasons good venture investors turn down good deals.

Fundable deals are often turned down because a fund is out of dry powder, defined as fund capital not already invested in, or set aside for, current portfolio companies. The “set aside for” phrase here is the one that sometimes confounds entrepreneurs. When a (competent) venture investor puts say $X into a startup the investor almost certainly makes a mental note to reserve another dose of capital for future investment in the company. That number, let’s call it $Y, can vary from deal to deal, and over time as a particular portfolio company, and the fund’s portfolio, evolves. That said, a good rough assumption is that if a fund has actually invested 50% of the capital in its active portfolio companies the fund is likely “fully invested” and thus does not have any dry powder available to commit to a new deal, like yours.

(Why, you might ask, would a fund bother talking to an entrepreneur if the fund doesn’t have any dry powder available to do the deal in any event? First and foremost, because venture investors want to stay current on market conditions and deal flow wherever they are in terms of their own investing cycle. In terms of managing their current portfolio investments, keeping up with emerging competitive trends is, of course, useful as well. And in terms of thinking about raising their next fund, staying current is critical to their own fund raising pitch.)

Funds also commonly turn down a fundable deal because it doesn’t fit with the fund’s investment strategy or theme. Most fundable deals that are out of the comfort zone of a fund – say a biotech deal getting turned down by a fund that focuses on the IT space – get turned down without a time-wasting reading of the plan, much less a meeting. Now and then, however, it takes a fairly close look to see that a deal doesn’t quite hit a fund’s sweet spot.

Which leads to two other reasons fundable deals get turned down. First, a benign and quite common one. No one at the firm, after reading the plan and taking a meeting, is excited enough to do any more work. I am an investment adviser to a small angel fund, and a couple weeks back we looked at a pretty well put together plan for a business that was clearly in our sweet spot. Alas, while we liked the entrepreneur, and the plan was technically pretty solid, no one on the investment team was really excited about the deal. At a gut level, no one “got it.” That may not seem like a very good reason to turn a deal down (“yeah, well, I can’t really say why, but it just doesn’t excite us”), but it happens all the time. Good investors won’t do a deal just because they like it at a gut level, but they almost never do a deal that they don’t like at that level.

Next, something for the conspiracy theorists in the audience. Most venture investors that I have known, even many of those wearing more or less white hats, will happily spend some time with an entrepreneur who passes the blush test and also looks like a real or possible competitor of one of their portfolio companies. Most won’t try too hard to solicit information they shouldn’t, but neither will they tell a talkative entrepreneur to keep quiet. If that seems unfair, well, no one ever said life – or high impact entrepreneurship – is always fair. (If this makes you think you should get an NDA before you have a first meeting with a venture investor…., think again. For some good, bad and indifferent reasons, VCs don’t sign NDAs.)

Perhaps the “best” reason a fundable deal gets turned down, if also maybe the most frustrating for the entrepreneur, is the “really good deal … but we can only do so many deals and, well, we have another one we like just a little bit more” turn down. The fact is, even funds flush with cash can only do a limited number of deals. Both capital and people resources are finite, and the better the quality of a fund’s deal flow, the more good deals they turn down.

Finally, your deal might be one of those that get turned down because the venture investor in question just plain made a mistake. As, for example, Benchmark turned down PayPal.

So the next time your presumably fundable deal gets turned down, you can take some solace in the notion that most fundable deals get turned down. Indeed, unless you have a solid track record making money for venture investors before, you should plan on a lot of turn downs before someone recognizes yours as a deal that they just have to do.

While Convertible Debt with a “kicker” of some sort (typically either in the form of warrants or a discount on the conversion price) was first used primarily as a structure for bridging companies between rounds of traditional venture capital financing, more recently it has become a popular vehicle for seed financing in advance of the first (“A”) round of venture investment. The structure offers two major plusses for entrepreneurs and investors. First, it postpones the valuation negotiation until both parties have a better handle on the key variables. Second it is faster and cheaper to implement than a formal Series A round.

That said, like most ideas that have been around for a while, convertible debt has found its way into more situations where it may not be a very good fit. Today, my focus is exploring the situational limits of the convertible debt financing structure in the startup context.

Conceptually, the convertible debt structure works when an entrepreneur seeks a modest round of risk capital to achieve a significant milestone in a short period of time, the accomplishment of which will set the stage for a substantially larger subsequent A round of financing. Framed this way, the terms “modest” and “substantially” are linked, while the terms “significant” and “short” are more or less independent.

Let’s start, then, with the “modest” and “substantially” discussion. Essentially, the notion here is that the bigger the difference between the seed round need and the A round need, the more a convertible debt structure makes sense. Depending on the kind of deal (think bigger in capital intensive businesses) and the seed capital market (think bigger in venture capital centers) a convertible debt seed round might be anywhere from $5k to $1 million or more. The critical point is that the expected A round be substantially larger. How much is that? My thinking is that in general the A round should be at least 2x and ideally 3x or more the size of the seed round.

The reason the A round should be at least twice the size of the seed round is that if the seed round gets much bigger the impact of the seed round kicker on the A round valuation negotiation will at some point cross the fuzzy line from marginal (and thus largely overlooked) to central (and thus problematic). For example, consider a $500k convertible note with a 20% discount on conversion. If the subsequent A round is a $5 million raise, the seed round kicker (basically, the seed folks will get an extra $100k worth of A round stock) represents roughly 2% of additional dilution to the A round investors. In theory the A round investors might factor that 2% into the A round valuation discussion. In practice, probably not.

On the other hand, if the A round in the above example is just $1 million, the overhang from the 20% kicker looms much larger. In fact, it now represents roughly an additional 10% dilution to the A round investor. At this point, what was a theoretical issue for the A round investors, in terms of the valuation negotiation, might be a practical issue as well. As such, it will likely complicate the A round valuation discussion, and likely result in a lower A round valuation – and corresponding additional dilution for the entrepreneur. (Alternatively, some or all of the additional dilution might be shared with the seed round investors, if they can be “persuaded” to waive some or all of the seed round kicker.)

Let’s turn now to the “significant” milestone variable in the seed convertible debt scenario. What constitutes a “significant” milestone? Essentially, two related concepts play into what constitutes a significant milestone. The more central of the two is the notion that significance is measured by how much risk the accomplishment of the milestone takes out of the deal. Particularly at the early stages of a high impact business, the primary driver of value is risk reduction. The seed milestone should be well-defined, and the accomplishment thereof should reduce the risk that the deal will get to a satisfying exit by … say 25% to 50%. (That might seem like a lot, but really just reflects how risky high impact entrepreneurship really is.) In addition, though in fact another way of framing pretty much the same issue, the accomplishment of the seed milestone should provide a much firmer foundation for the valuation discussion at the A round.

In my own world, I see a lot of web-centric startups where the seed round milestone is the delivery of the proverbial minimally viable product coupled with some modest customer validation. The significance of the same – the transformation of the entrepreneur’s idea into an actual product that at least a handful of folks in the target market will buy – is pretty obvious, both in terms of risk reduction and firming up the A round valuation parameters.

Finally, let’s consider the “short” time variable in the seed convertible debt scenario. This is in some ways the trickiest variable, I think, because it doesn’t so much depend on the practical demands of the convertible debt structure as the extant market dynamics. By that I mean that the bounds of the time variable are more a function of the market’s determination that an acceptable seed round kicker is something between 10% and 30% than any conceptual limits on the amount of time expected between the seed round and the A round. The notion here is that the seed round investors will accept a relatively modest 10% to 30% kicker on the assumption that the return will be over a reasonable period of time.

What is reasonable? In my experience, no more than 18 months, and generally less than 12 months. Why? Because if the implicit rate of return on the seed debt falls too far below the expected A round return (which might eye-balled at something like 100% from A round to B round) the seed round investors will quite rightly wonder whether their generosity in providing seed capital with only a modest kicker has crossed into philanthropic territory. And while I have known a lot of seed investors who think giving back some of their own good fortune by supporting the next generation of entrepreneurs is a wonderful thing, I have not found many who think giving away their good fortune to a next generation entrepreneur is a good thing.